As you begin to choose between different asset classes for investment, or even different assets within the same class, you need to consider your tolerance for risk. The risk profiles of even closely related securities, such as stocks that pay dividends and those that do not, can vary considerably.
Understanding your risk tolerance makes it easier to choose appropriate investments and expand your portfolio in a way that supports your personal goals and comfort level. However, identifying your risk tolerance is easier said than done. The term risk tolerance refers to the amount of risk you are willing to accept with your investments. Risk simultaneously means potential for growth and the possibility of losing big.
A significant part of risk tolerance that sometimes gets overlooked has to do with market swings and uncertainty about the future. If you tend to be a reactive investor who gets nervous when the market experiences a swing, high levels of risk may not be best for you as low levels of risk will help you feel more secure in your position. For many investors, loss aversion plays a bigger role in risk tolerance than the potential for gains. Remember that risk tolerance changes over time and needs to be revisited frequently.
You can ask yourself questions to tease out your personal risk tolerance. Here are four of the most informative questions to ask:
1. What is your investment horizon?
An important factor to consider in relation to risk tolerance is time. This is also a factor that will change, so it may affect how you approach risk. As a general rule, the longer it will be before you need to withdraw your money, the more risk you can accept because you have time to recover from losses.
Historically, the stock market has returned about 7 percent annually after accounting for inflation provided that you can wait out the downturns. With a shorter investment horizon, this is not always the case, and you could find yourself locked into significant losses.
For this reason, people tend to get more conservative as the amount of time before they will need the money grows closer. Assuming less risk reduces the chances that you have a sudden decrease in the value of your portfolio. As the time horizon changes, so too will your risk tolerance.
2. What is your investment goal?
What your goals are also affects your risk tolerance. Young people saving for retirement tend to accept greater risk because of the long amount of time before the money will be needed. However, if you intend to buy a house or to fund a child’s education, then you have a much shorter time horizon and may have a lower risk tolerance.
Goals can also have an influence on risk tolerance outside of the time horizon. For example, imagine that you hope to leave your grandchildren an inheritance. Your risk tolerance for a goal like this will be different than it would if you are saving for your own retirement.
Defining goals will help you create a pathway to follow to achieve them, which will force you to think more critically about risk. Remember that you can have multiple goals at the same time and need to prioritize them appropriately.
3. What kind of financial cushion do you have?
Another consideration is how robust your liquid savings are. Ideally, you already have an emergency fund that you can access in the event of a job loss or accident. However, this is not always the case or perhaps the fund is not quite as large as you would like. In this case, you may need to liquidate investments in the event of an emergency.
This may make you less tolerant of risk since you may end up relying on your investment accounts in the short term. If the investment accounts take a big loss, you could be in a difficult financial place should an emergency occur. On the other hand, if you have a healthy emergency fund, then you may be more accepting of investment risk since you will unlikely need the invested money in the short term.
4. How much do your emotions drive you?
Understanding your relationship to emotions is important in calculating risk tolerance. If you know that your emotions often drive your decision-making, then you may benefit from a portfolio with lower overall risk that minimize losses. Investors driven by emotion sometimes react by selling during down markets, locking in losses rather than waiting for prices to rebound.
However, if you can control your emotions and approach situations objectively, then you are more likely to wait out the market downturns and again see the value of your portfolio restored. Be honest with yourself and your emotions and protect yourself from doing things that will cost you money down the line. Your relationship with your emotions may also change over time as you learn more and get comfortable with investing.
Julio Herrera Velutini 